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In Discussion Paper No. 1131, Research Fellow Maurice Obstfeld and Kenneth Rogoff argue that, until now, thinking on open economy macroeconomics has been largely schizophrenic. Most of the theoretical advances since the late 1970s have been achieved by assuming away the awkward reality of sticky prices and instead developing the implications of dynamic optimization by the private sector. While the intertemporal approach has proved valuable for some facets of current account analysis, many of the most fundamental problems in international finance cannot be seriously addressed in a setting of frictionless markets. This paper offers a theory that incorporates the price rigidities essential to explain exchange rate behaviour without sacrificing the insights of the intertemporal approach to the current account. The authors develop an analytically tractable two-country model that marries a full account of global macroeconomic dynamics to a supply framework based on monopolistic competition and sticky nominal prices. The model offers simple and intuitive predictions about exchange rates and current accounts that sometimes differ sharply from those of either modern flexible price intertemporal models or traditional sticky price Keynesian models. For example, the model predicts that money supply shocks can have real effects that last well beyond the time frame of any nominal rigidities, due to induced short-run wealth accumulation via the current account. It also finds that an unanticipated permanent rise in world government purchases temporarily lowers world real interest rates: when prices are sticky, the government spending shock raises short-run output above long-run output, and world real interest rates fall as agents attempt to smooth consumption. Overall, the analysis leads to a novel perspective on the international welfare spillovers due to monetary and fiscal policies. Exchange Rate Dynamics Redux Maurice Obstfeld and Kenneth Rogoff Discussion Paper No. 1131, February 1995 (IM) |